Insights
European and Japanese investors: Consider not fully hedging your USD exposure

Global Fixed Income Bulletin

•

July 12, 2019

European and Japanese investors: Consider not fully hedging your USD exposure

Insights
European and Japanese investors: Consider not fully hedging your USD exposure

European and Japanese investors: Consider not fully hedging your USD exposure

Global Fixed Income Bulletin

European and Japanese investors: Consider not fully hedging your USD exposure

Global Fixed Income Bulletin

European and Japanese investors: Consider not fully hedging your USD exposure

European and Japanese investors: Consider not fully hedging your USD exposure

July 12, 2019

Europe- and Japan-based investors typically hedge all foreign currency exposure back to their local currencies, but is this the best practice? We have computed several FX hedge ratios and find that fully hedging USD exposures may be suboptimal. We estimate an optimal FX hedge ratio of around 66% for euro-based investors and 80% for Japan-based investors. When allowing for monthly rebalancing of the hedges, we find that the optimal FX hedge ratios are, on average, very close to the static ones, but are volatile and change drastically during episodes of heightened risk aversion.

×

As an example of this common practice, an asset manager
residing in the euro area with exposure to the USD-denominated
JPMorgan EMBIG Index (a benchmark
comprising hard-currency-denominated sovereign and quasi-sovereign
debt), may offset the USD exposure by entering
a matching long EURUSD (eurodollar) position through a
derivative (usually, an FX forward or swap).

However, this practice can be expensive, particularly in the
current environment where euro and Japanese yields are
significantly below U.S. yields. That is, these hedges incur
negative carry because being long EUR (or JPY) vs. the
USD is equivalent to borrowing in USD at a given rate, and
investing the proceeds at a much lower EUR (or JPY) rate.
Furthermore, given the typical underperformance of the
EUR vs. the USD during spikes in global risk aversion,
the cost of fully hedging USD exposure back to EUR could be even higher. The opposite
may occur for Japanese investors: JPY
tends to rally in risk-off scenarios
and the optimal response would be to
over-hedge.1 Therefore, 100% FX hedge
ratios are not necessarily the optimal
way to manage the USD exposure.

In this paper, we look at several FX
hedging strategies proposed by finance
literature with the goal of calculating an
optimal FX hedge ratio of an underlying
USD position. We will examine both
static hedging strategies, where the
FX hedge ratio remains constant
throughout the investment horizon,
and more realistic dynamic hedging
strategies, where the hedge ratio is
rebalanced frequently. All the metrics
considered in our sample suggest
that euro- and Japan-based investors
should consider only partially
hedging their USD exposure.

Moreover, dynamic FX hedge ratios
are, on average, similar to the static
ones. However, they are volatile and
exhibit sudden spikes during periods of
heightened risk aversion, leading to FX
hedge ratios that can materially deviate
from the static ones.

The results presented here are illustrative
and do not imply investors should
follow the recommendations, as the
truly optimal hedge ratio will be
a function of the underlying USD
exposure, current market conditions,
and individual investors’ views about
expected returns of both the underlying
and hedging assets. However, we believe
the computed FX hedge ratios are
similar enough to provide managers
with a useful framework on how to
manage FX risks.

Two frameworks to calculate optimal FX hedge ratios
There are many criteria that may guide the search for the optimal FX hedging ratio.2 The general approach is to pick the FX hedge so that it optimizes a certain objective. Typically, the investor chooses an FX hedge ratio that minimizes the volatility of the hedged portfolio return.3 Such a risk minimization framework may provide useful results, particularly when the expected return of the FX futures contract is zero, that is, when the positive interest rates differential exactly offsets the expected FX depreciation implied by the forwards.

However, when investors’ views about the currency differ from those implied by the market, the risk minimization framework is not flexible enough.

Therefore, we also study a risk-adjusted maximization framework to reflect the risk-return trade-off in hedging FX exposure. The appendix provides definitions for the specific criteria we consider when implementing both approaches.

Static and dynamic FX hedge ratiosThe metrics we considered are typically calculated under the assumption that the FX hedge ratio will remain unchanged throughout the entire investment horizon, regardless of possible changes in market conditions.

However, the volatilities and correlations among asset returns vary: an FX hedge ratio that fails to adjust to changing market environments is likely to underperform. Therefore, we also calculate an FX hedge ratio alternative4 that can be adjusted every month, and depends on estimates of volatilities and correlations of asset returns at the time of each rebalancing.

Source: Morgan Stanley Investment Management, Bloomberg. Data from January 1999 through May 2019.

Euro- and Japan-based investors: you may be better off partially hedging your USD exposure
Both static and dynamic FX hedge ratios are computed for hypothetical euro- and Japan-based investors holding a single USD exposure, represented by the JPMorgan EMBIG benchmark index. The data for the analysis consists of unhedged EUR and JPY monthly EMBIG returns, and returns for 1-month EURUSD and USDJPY FX forwards, spanning the period January 1999-May 2019, for a total of 248 observations. All the data is available in Bloomberg.

Optimal FX hedging ratios for EURbased investors are typically in the 60%-80% area though there is some variation depending on the optimality criterion (see left side of Display 1). All these metrics imply lower FX hedge ratios than the usual practice of fully hedging one’s FX exposure.

When we consider mean-risk hedge ratios, that is, those that attempt to strike an optimal balance between risk and expected return, the results for the eurobased investors are in line with intuition: they tend to prescribe slightly lower FX hedge ratios than those obtained from a pure risk-minimization framework. This is because mean-risk hedge ratios take into account the expected return of the long one-month EURUSD forward contract, which we estimated as slightly negative, at 6 basis points per month.5 That is, there is a cost to hedging the USD exposure because the appreciation of the EUR vs. the USD during the sample period did not compensate for the negative EUR-USD rate differential.

We ran the same calculations for a hypothetical Japanese manager with a USD exposure via the EMBIG benchmark. The minimum-variance (MV) approach recommends a Japanese investor to hedge about 88% of the USD exposure. Other risk-based measures prescribe similar FX hedge ratios, but one interesting result of these calculations is that the optimal FX hedge ratios for Japan-based investors are uniformly higher than those prescribed to the EUR-based investor. This is partly explained by the fact that the JPY forward is a better hedging asset than the EUR forward, because the JPY forward returns correlate better with the unhedged returns of the underlying, than in the EUR case.

However, when we consider risk-adjusted measures of expected returns, the optimal FX hedges for a Japan-based manager can sometimes be lower than those calculated for the euro-based manager. These results reflect the higher negative carry of long JPY positions (versus EUR longs) used to hedge the USD exposure. In other words, because JPY rates in the time sample considered were, on average, lower than their EUR equivalents, hedging with short USDJPY forwards is more expensive, thus lowering the optimal hedge ratios prescribed by mean-risk based approaches.

Dynamic hedge ratios are volatile and react significantly to spikes in risk aversion
In this section, we go beyond constant FX hedge ratios to consider frequently rebalanced hedges based on monthly estimates of return volatilities and correlations among assets. Display 2 reports these dynamic FX hedge ratios for both euro- and Japan-based managers.

Dynamic FX hedge ratios exhibit significant variation, typically fluctuating in an interval between 50% and 100%. The average EURUSD hedge ratio is about 76%, which is broadly in line with static hedges. Similarly, for Japan-based investors: the average FX hedge ratio is about 87%, very close to the constant hedges.

However, there are significant spikes in hedge ratios, most notably during the global financial crisis in the second half of 2008. Up to September 2008, a euro-based investor following a dynamic hedging strategy would have been fully hedging the USD exposure, whereas a Japanese investor would have hedged about 90% of it. In the two subsequent months, these optimal FX hedge ratios would have drastically changed: the euro-based investor would have reduced FX hedges to a net USD exposure of 121% of the underlying USD position by November, while a Japan-based investor, on the contrary, would have overhedged by increasing short USDJPY positions to 250% of the USD exposure in November 2008 (see Displays 3 and 4).

The sharply asymmetric response of the EUR and JPY FX hedges in stress scenarios reflects the fact that in riskoff environments, the USD tends to appreciate versus the EUR (because of the latter’s high beta to the VIX, a proxy for risk aversion), but typically depreciates against the JPY (as spikes in risk aversion prompt investors to unwind carry trades, which are funded by low yielding currencies, such as JPY or CHF).6 In fact, during the October-November 2008 period, the EUR depreciated by 11% against the USD, while the JPY strengthened by the same amount.

×

DISPLAY 3: Euro-based investor would have gone net long USD during the Global Financial Crisis...



Source: Morgan Stanley Investment Management, Bloomberg. Data from January 1999 through May 2019.

×

DISPLAY 3: Euro-based investor would have gone net long USD during the Global Financial Crisis...

Source: Morgan Stanley Investment Management, Bloomberg. Data from January 1999 through May 2019.

DISPLAY 4: ...whereas a Japan-based manager would have overhedged the USD exposure



Source: Morgan Stanley Investment Management, Bloomberg. Data from January 1999 through May 2019.

×

DISPLAY 4: ...whereas a Japan-based manager would have overhedged the USD exposure

Source: Morgan Stanley Investment Management, Bloomberg. Data from January 1999 through May 2019.

Conclusion
We put the theory of futures hedging to
use to address the situation European and
Japanese investors face when managing
USD exposure. The main takeaway
is that fully hedging USD exposure
back to domestic currencies appears
to be suboptimal, as all the risk-based
approaches we examined point to optimal
FX hedges around 66% for euro-based
investors and 80% for Japan-based
managers. Mean-risk approaches, which
factor in the cost of hedging USD
exposure with long EURUSD and short
USDJPY positions, suggest even lower
hedge ratios. Finally, to account for timevarying
volatilities and correlations, we
explored dynamic hedge ratios that are,
on average, close to those prescribed by
static methods, but that exhibit significant
volatility and change suddenly in response
to spikes in global risk aversion.

×

Appendix
In this section, we introduce the specific objective functions that we used to calculate the optimal FX hedge ratios:7

MINIMUM VARIANCE (MV): under this approach, the investor picks the hedging ratio that minimizes the variance of the return of a portfolio comprising the USD exposure and FX forwards (either a long EURUSD or short USDJPY forward). The MV objective is consistent with an investor that is extremely risk-averse and/or when the expected return of the forward is zero (i.e., the interest rate differential between USD and EUR (or JPY) exactly offsets the expected change in the EURUSD (or USDJPY) spot).

MEAN-VARIANCE (MEAN-VAR): this method takes into consideration the trade-off between risk and return when deriving the optimal hedging ratio. Unlike the MV approach, it can accommodate for FX views that differ from what is being priced in by the forwards.

SHARPE RATIO (SR): this approach offers another way to account for the risk-return tradeoff of the hedging portfolio that does not require specifying investors’ preferences toward risk (unlike the mean-Var approach). More specifically, the investor adjusts the hedging ratio of the USD bond position to maximize the risk-adjusted expected return of the hedged portfolio, net of a risk-free rate (given by U.S. LIBOR).

EXTENDED GINI (EG): the Extended Gini coefficient is an alternative measure of risk, which has better statistical properties than the previous MV criterion, and is less restrictive on assumptions regarding the distribution of returns or investors’ risk preferences. Within this approach, the manager picks the FX hedge ratio that minimizes the EG function.

MEAN-EXTENDED GINI (MEAN-EG): this measure builds on the EG criteria by also incorporating the expected return on the hedged portfolio. Therefore, the investor will pick the hedge ratio that maximizes the mean- EG objective function.

GENERALIZED SEMIVARIANCE (GSV): unlike the traditional variance measure, which captures dispersion around the mean on both sides of it, the GSV captures the notion of downside risk, thus better aligning with the asymmetric way portfolio managers tend to view risk (for example, negative returns are perceived as more risky than positive returns).

MEAN-GSV: this approach adds the expected return of the hedged portfolio to the GSV metric, to compute an optimal hedge.

MULTIVARIATE-GARCH: this approach, by assuming asset return correlations and volatilities change with time, allows us to compute dynamic FX hedge ratios that vary month-to-month depending on market conditions. GARCH stands for Generalized Autoregressive Conditional Heteroskedasticity. In plain English, this approach attempts to capture the tendency of a financial variable’s volatility to change through time and its persistence (“volatility begets volatility”).

×

1 A comprehensive study of currency responses to risk-off events can be found in De Bock and De Carvalho Filho, “The Behavior of Currencies during Risk-off Episodes,” IMF Working Paper No. 13/8, 2013.

2 For those interested in the broad issue of hedging a position (it could be equities, bonds, FX, commodities, etc.) with futures contracts, please refer to a comprehensive survey by Chen, Lee and Shrestha, “Futures Hedge Ratios: A Review,” The Quarterly Review of Economics and Finance, 43 (2003) 433-465.

3 The variance is the traditional measure of risk or volatility, but the financial literature has examined alternative metrics that are less restrictive. In particular, risk measures, such as the Gini coefficient and the semi-variance can also be considered to compute optimal FX hedge ratios. Please refer to the appendix for definitions.

4 The specific approach we consider is a multivariate GARCH method. See appendix for further details.

5 We use historical average monthly returns as proxies for expected long EURUSD one-month forward and EUR-unhedged EMBIG returns. In turn, EMBIG unhedged returns can be broken down into two components: a USD-denominated return (due to carry and duration) and an FX return (for eurozone-domiciled investors, a depreciation of the EUR against the USD is another source of positive return).

6 See reference in fn.1.

7 See reference in fn.2.

×

Risk ConsiderationsFixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In the current rising interest rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. Longer-term securities may be more sensitive to interest rate changes. In a declining interest rate environment, the portfolio may generate less income. Certain U.S. government securities purchased by the strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. High-yield securities (junk bonds) are lower-rated securities that may have a higher degree of credit and liquidity risk. Sovereign debt securities are subject to default risk. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. The currency market is highly volatile. Prices in these markets are influenced by, among other things, changing supply and demand for a particular currency; trade; fiscal, money and domestic or foreign exchange control programs and policies; and changes in domestic and foreign interest rates. Investments in foreign markets entail special risks such as currency, political, economic and market risks. The risks of investing in emerging market countries are greater than the risks generally associated with foreign investments. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk). Due to the possibility that prepayments will alter the cash flows on collateralized mortgage obligations (CMOs), it is not possible to determine in advance their final maturity date or average life. In addition, if the collateral securing the CMOs or any third-party guarantees are insufficient to make payments, the portfolio could sustain a loss.

DEFINITIONSDuration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. Rising interest rates mean falling bond prices, while declining interest rates mean rising bond prices.

Forward is a derivative security that is a non-standardized contract between two parties to buy or to sell an asset at a specified future time and price.

A swap is a derivative contract through which two parties exchange financial instruments.

INDEX DEFINITIONS
The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

The JP Morgan Emerging Markets Bond Index Global (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets and is an expanded version of the EMBI+. As with the EMBI+, the EMBI Global includes U.S. dollar-denominated Brady bonds, loans and eurobonds with an outstanding face value of at least $500 million.

DISTRIBUTION
This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16 percent per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”), (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This material has not been reviewed by the Monetary Authority of Singapore. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.

There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s/product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.

The results referenced are hypothetical, based on our model, provided for illustrative purposes only, and is not intended to represent historical, or predict future results. Any changes to assumptions and factors considered herein could have a material impact on the results set forth herein. No representation is being made that any hypothetical data provided herein will or is likely to come to pass. Actual results will depend, to a significant degree, on actual valuations, market conditions, and other contingencies.

A separately managed account may not be suitable for all investors.

Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing.

The views and opinions are those of the author or the investment team as of the date of preparation of this material and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all investment teams at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.

This material is a general communication, which is not impartial and has been prepared solely for informational and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. All investments involve risks, including the possible loss of principal. The information herein has not been based on a consideration of any individual investor circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.

Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.

MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. Additionally, financial intermediaries are required to satisfy themselves that the information in this document is suitable for any person to whom they provide this document in view of that person’s circumstances and purpose. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary.

This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.

The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.

All information contained herein is proprietary and is protected under copyright law

×

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.